Economics – Hedging Strategies: Restrictions and Problems

Words: 267
Topic: Business & Economics
Updated:

Dynamics of supply and demand in the oil industry and the global financial issues have resulted in unprecedented instability in prices of the commodity in the past few years. Meanwhile, oil refiners have faced sudden changes in profitability. Consequently, many refineries have adopted different hedging strategies as attempts to manage market instability and, to some extent, avoid situations that could lead to bankruptcy.

Hedging strategies can work well about financial, strategic, and operational outcomes if refiners can implement them effectively. Hence, refiners can protect their earnings and create values for shareholders. Conversely, a poorly done hedging for oil commodities could exceed its logic and destroy a firm.

First, refiners may fail to analyze the net economic exposure if they engage in too many hedging activities to counter the potential risks of different business units without evaluating hedging activities in other units. This strategy may fail to account for aggregate risks, including indirect consequences for the entire firm.

Second, refiners may fail to understand, or they may underestimate the actual cost and benefits of hedging by concentrating specifically on immediate transactional costs like bid and broker charges, which could only be small fractions of the total hedge cost.

However, there could be other larger indirect costs of hedging, which may make the strategy ineffective. Finally, refiners should only hedge exposures that present immediate financial risks and threaten their strategic objectives. However, under most circumstances, refiners may use hedging strategies that could result in little or no value to investors. This could happen because of pressure from capital markets or business units that focus on profits and high returns.